Wall Street Losses Reach Half of Post 2004 Profits (And the Fat Lady Has Yet to Sing)

Today’s New York Times provides an interesting bit of context for investment banks woes: losses from July 2007 to present roughly equal the profits earned from the beginning of 2004 through that date.

The story merely alludes to the question of whether the rich bonuses of the boom years were warranted, but broaches another topic that the former Masters of the Universe may not want to consider: the industry is going to experience secular as well as cyclical changes. Drastic falls in employment are normal in the securities industry (peak to trough declines are typically 20%) and bonuses fall even more dramatically (producers who one earned in the $1 to $3 million range in the dotcom era had to make do with a mere $300,000 to $400,000 in the last downturn).

But at a minimum, investment banks are just about certain to be required to keep higher equity levels, and that alone will reduce profits. If credit default swaps do indeed move to exchanges, that eliminates another lucrative revenue source. Additional reforms are may well reduce the attractiveness of other activities.

From the New York Times:

The numbers are staggering. Between early 2004 and mid-2007, a period of unprecedented wealth on Wall Street, seven of the nation’s largest financial companies earned a combined $254 billion in profits.

But since last July, those same banks — Bank of America, Citigroup, JPMorgan Chase, Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley — have written down the value of the assets they hold by $107.2 billion, gutting their earnings and share prices. Worldwide, the reckoning totals $380 billion, much of which reflects a plunge in the value of tricky mortgage investments…..

But the finish line just seems to keep moving further away. Even when the losses end, bank executives are looking toward a new era of lower returns, thinner profits and fewer jobs….

“They are going to have to build a new business model,” Richard X. Bove, a financial services analyst at Punk Ziegel, said of investment banks. “I do not believe those businesses have the ability to generate the kind of profit they did in recent years without all the leverage.”…

The latest round of results is likely to draw special scrutiny because Wall Street firms are disclosing capital levels under new international banking standards known as Basel II. And Merrill Lynch, Citigroup and UBS are also expected to suffer from the ratings downgrades recently issued for MBIA and Ambac, two bond reinsurers….

“It’s a fairly unique situation, that you would give so much back,” said Alec Young, global equity strategist for Standard & Poor’s Equity Research. “The industry did enjoy real salad days over that period, but now the write-downs and losses have been so huge. It’s a significant percentage of the money generated.”

Even the winners in this cycle — JPMorgan Chase and Goldman Sachs — have had to pull out giant erasers to work through their loan books. JPMorgan, which had the financial heft to buy Bear Stearns, wiped out 15 percent of recent profits by lowering the values of its loan and mortgage assets. At Goldman, the cost of such write-downs is so far 12 percent of recent profits.

The banks are supposed to be especially good at valuing all the lumps of loans and assets they own. That is why many a Wall Street bonus is based on estimates of hard-to-value dealings in arcane assets. The very mortgage bonds that are now being written down, in fact, led to hefty bonuses for bank employees before the good times ended.

Some analysts predict that independent brokerage houses will merge with commercial banks, if the government begins regulating them. That uncertainty leaves executives at these companies unsure of how to plan for the future, said David Trone, an analyst at Fox-Pitt Kelton Cochran Caronia Waller, who is predicting bank consolidation.

“We’re in a weird limbo now,” Mr. Trone said.

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  1. Tom Lindmark

    Sort of a depressing article. Do you think that a financial system composed of a few, large, highly regulated firms is in our best interest?

  2. Stephen

    Many of the losses are based on “Marked-to-market” accounting. If the market has over corrected in its declined pricing of MBS and other CDOs, the losses currently being booked may be paper only losses, and turn out to be nothing more than a tax savings for the firms. I am not saying that there aren’t losses, just that the losses may be overstated to some extent. I have seen this to some extent personally in the overreaction of OCC regulators in the downgrading of credits in regional banks, requiring reserves on many credits that will most likely not turn into actual losses.

    Now, if the firms are over-leveraged and run into liquidity problems like thornburg and bear… it doesn’t much matter what the actual losses turn out to be.

    my 2 cents

  3. Bitter Renter

    I wouldn’t worry too much about the “Masters of the Universe.” They will shift their activities to a different unregulated corner of the financial profession.

    The following areas come to mind: hedge funds, private equity, and venture capital. These are all areas where the SEC has little oversight authority.

  4. Anonymous

    I feel like I am caught between main street and wall street and see both sides. I don’t see the worry I should from the wall street players of what main street is thinking or capable of. Can someone explain to me what a modern day revolution would look like and how it would go down?

  5. Richard Kline

    I draw three conclusions from this NY Times article. First, if top tier financials can’t generate large profits without moving exceedingly large volumes of borrowed money around to rake off fees (the function of all that ‘over-leverage’), this tells us plainly how LITTLE value added there actually is in their business model. Without destabilizing churn, these concerns simply aren’t exceptionally profitable.

    Second, if to pay out their large employee bonuses top tier financials can’t at the same time maintain significant capital reserves against losses, those bonuses _are overtly parasitical_ of the firms themselves. A well-reserved financial concern simply isn’t as spectacularly profitable for its employees.

    If spectacular ‘profits’ at a cyclical top are eventually discovered to be spectacular losses under less piggy conditions, then there really wasn’t all that much _actual profit_ in that leverage, just actual debt. Which somebody else was expected to get stuck with. If I did that with my credit card, it’s called fraud. The line between mastery and criminality in finance looks rather like the same line, just with different names for the head and the foot of the queue.

    To Stephen of 12:57, any assumption that prices for MBSs have ‘over-corrected’ is a helluva stretch. Yah, sure, _if_ they have over-corrected than the holders of those instruments will be sitting pretty: Why, then are the holders trying to move them while the market is trying damn hard to move away from them? Foreclosures and their attendant price declines are still accelerating; could that be the reason? At some point, some tranches of some MBSs or other ABSs will yield more than their holders paid for them; few present holders will ever finish in the money, though. Most present holders face further _real_ losses on these assets, not paper ones.

  6. Anonymous

    ☺☺Richard Kline said…
    “…this tells us plainly how LITTLE value added there actually is in their business model. Without destabilizing churn, these concerns simply aren’t exceptionally profitable.”

    Richard, I would take that one step further. I believe the entire financial sector is bloated. Take this observation from the NY Times article:

    “For now, investors are not holding out hope. They have dumped bank stocks with each round of bad news, and recently the financial sector lost its perch atop the nation’s stock market. The combined value of technology shares, those darlings of yesteryear, has eclipsed that of financial stocks. And the energy sector is not far behind.”

    There is something horribly wrong with a society that values its productive sectors much less than its financil sector. Don’t I recall something in the Bible about money changers in the temple?

    Anyway, if we are going to get back to anything resembling a healthy, productive economy, technology and energy need to rise further and the financial sector still has a long way to fall.

  7. Lune

    Do you think that a financial system composed of a few, large, highly regulated firms is in our best interest?

    As opposed to a few, large, highly unregulated firms…?

    Also, WRT the original article, it’s not at all true that the losses have erased the profits of financial firms. It’s erased shareholders’ profits. In financial firms, much of the profits of their business activity get funneled to employees through outrages salaries and bonuses, while the shareholders and equity investors get saddled with losses.

    When the net worth of the executives of these firms goes back to 2004 levels, that’s when you know a full accounting of profit/loss has taken place. I’m not holding my breath for such a correction, however.

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